Rich will have to pay piper

John Quiggin
Australian Financial Review

18 June 2008

The Rudd government is entitled to feel reasonably satisfied with its economic management so far. Through a combination of good luck and well-timed economic stimulus, Australia has suffered far less from the global financial crisis than most other countries. With at least some chance of a global recovery towards the end of 2009, there is a good chance that we can resolve our own economic imbalances, such as the still overheated housing market, without a sharp downturn.

But, even after the crisis is resolved, the problems of economic management will not get any easier. Having accepted the large deficits necessary to maintain economic activity, the government must steer the budget back to surplus. Despite the optimistic projections in the May Budget, this task cannot be achieved without a significant increase in tax revenue.

The proposed path back to surplus is based on a plan to hold the real rate of growth in public expenditure to 2 per cent, once economic growth recovers. But large areas of public expenditure, such as pensions, defence and interest on public debt have significant increases locked in. Unemployment will remain high and require additional expenditure long after economic activity starts to recover. Unless the government is to repudiate its commitments in areas like health and education, there is no realistic path to the 2 per cent target.

The distinction between tax and expenditure is problematic in itself. Some of the biggest areas for potential saving are with respect to tax expenditures such as the health insurance rebate and superannuation concessions. Tax expenditures proliferated under the Howard government as a means for delivering middle class welfare and cuts in this area are an obvious source of new funds. But, since reductions in tax expenditures appear as increases in taxation, they will not help the government to achieve its 2 per cent target.

If expenditure is not to be constrained in this way, the only remaining route back to surplus is an increase in tax revenue. To allow public expenditure to grow in line with GDP over the recovery period, the ratio of tax to GDP would need to rise by around five percentage points over time. This would require the abandonment of the dogma, dating back to the Hawke government’s ‘Trilogy’ commitments, that the ratio of tax revenue to GDP should never increase. But the global financial crisis, and the international response to it, have fatally undermined this dogma.

Advocates of tax cuts made much of international tax competition. As recently as last week, Joe Hockey was talking about the risk that high income earners would move to London or New York in response to higher taxes. It perhaps escaped his notice that the UK has increased its top marginal rate of taxation to 50 per cent.

The US has raised taxes on the highest income earners, and this trend will inevitably continue. The observers across the political spectrum are agreed that the United States must increase tax revenue substantially to pay down its public debt and to finance the Obama Administration’s ambitious proposals for health care.

The economic case for lower taxes has been gravely weakened by the experience of the economic crisis. Low tax advocates pointed to the economic of success of countries like Iceland and the Baltic states which adopted flat tax systems to attract capital investment. While no country has escaped the global financial crisis, these countries have experienced a complete economic meltdown.

More generally, the idea that giving incentives to high income earners is an essential element of sound economic policy has been discredited by the global financial crisis. Far from planning sound investments to lay the basis for future prosperity, the highly-incentivised leaders of the global financial sector engaged in an orgy of speculation from which ordinary taxpayers have been forced to rescue them. Upper income earners as a group benefitted greatly from the (partly spurious) prosperity of the bubble era, and it is appropriate that they should bear some of the burden of recovery.

Capital gains taxes provide one obvious area of reform. Following the lead of the United States, Australia halved the rate of capital gains tax in the late 1990s. This step, taken at the height of the dotcom bubble, was supposed to promote venture capital investment. In fact, it simply fuelled the housing bubble.

The Henry review of the tax system provides the government with an opportunity to review this, and other failed products of the finance-driven political orthodoxy of recent decades. The government should seize this opportunity.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council
Federation Fellow in Economics and Political Science at the University of Queensland.